Table 20.2

Debt Ratios for Selected Industrial Countries

It is not clear why the financial structure of firms should vary so much across countries. One possible explanation is that different tax regimes determine the relative attractiveness of debt and equity in a country. For example, if dividends are taxed highly, a preference for debt financing over equity financing would be expected. However, according to recent empirical research, country differences in financial structure do not seem related in any systematic way to country differences in tax structure.⁸ Another possibility is that these country differences may reflect cultural norms.⁹ This explanation may be valid, although the mechanism by which culture influences capital structure has not yet been explained.

The interesting question for the international business is whether it should conform to local capital structure norms. Should a US firm investing in Italy adopt the higher debt ratio typical of Italian firms for its Italian subsidiary, or should it stick with its more conservative practice? There are few good arguments for conforming to local norms. One advantage claimed for conforming to host-country debt norms is that management can more easily evaluate its return on equity relative to local competitors in the same industry. However, this seems a weak rationale for what is an important decision. Another point often made is that conforming to higher host-country debt norms can improve the image of foreign affiliates that have been operating with too little debt and thus appear insensitive to local monetary policy. Just how important this point is, however, has not been established. The best recommendation is that an international business should adopt a financial structure for each foreign affiliate that minimizes its cost of capital, irrespective of whether that structure is consistent with local practice

Global Money Management: the Efficiency Objective

Money management decisions attempt to manage the firm's global cash resources--its working capital--most efficiently. This involves minimizing cash balances and reducing transaction costs.

Minimizing Cash Blanances

For any given period, a firm must hold certain cash balances. This is necessary for serving any accounts and notes payable during that period and as a contingency against unexpected demands on cash. The firm does not sit on its cash reserves. It typically invests them in money market accounts so it can earn interest on them. However, it must be able to withdraw its money from those accounts freely. Such accounts typically offer a relatively low rate of interest. In contrast, the firm could earn a higher rate of interest if it could invest its cash resources in longer-term financial instruments (e.g., six-month certificates of deposit). The problem with longer-term instruments, however, is that the firm cannot withdraw its money before the instruments mature without suffering a financial penalty.

Thus, the firm faces a dilemma. If it invests its cash balances in money market accounts (or the equivalent), it will have unlimited liquidity but earn a relatively low rate of interest. If it invests its cash in longer-term financial instruments (certificates of deposit, bonds, etc.), it will earn a higher rate of interest, but liquidity will be limited. In an ideal world, the firm would have minimal liquid cash balances. We will see later in the chapter that by managing its total global cash reserves through a centralized depository (as opposed to letting each affiliate manage its own cash reserves), an international business can reduce the amount of funds it must hold in liquid accounts and thereby increase its rate of return on its cash reserves.